What Is A Venture Capital Shareholder Agreement?
Are you a startup interested in learning more about shareholder agreements and the features likely to be included when fundraising with venture capitalists? You’re in the right place.
Venture capital shareholder agreements can vary in their sophistication but do share some key points. The potential pitfalls and problems that can arise through these documents will also be explored, allowing you to approach such documents with agency and insight.
Shareholder agreements for startups can be tricky as often an inexperienced founder, or team, is engaging with a much more experienced venture capitalist or angel investor. Creating a power imbalance.
By reading through this guide, you will be able to confidently navigate investment agreements.
Don’t miss out on the opportunity to get your business funded and ready for future success.
Venture capital shareholder agreements. What are they?
Venture capital shareholder agreements are a legal arrangement between different shareholders, in this case a venture capitalist.
A venture capitalist (VC) is an investor that makes capital available to companies in exchange for a share in the company. Venture capitalists usually fund companies with a high growth potential, such as startups.
The venture capital shareholder agreements generally cover how the company should be managed, along with the rights and obligations of each of the shareholders.
A shareholder (or stockholder) is any person or company that owns a portion of a company’s stock, otherwise known as equity. Shareholders are essentially part owners of a company and can benefit from its success. Rewards come from generating profits and increasing the value of the company.
Shareholder agreements for a startup are important as they protect all parties and make clear what the responsibilities of each part are. The protection works both ways, with the founders being able to protect themselves from investors making decisions the founders don’t feel are beneficial to their startup, and investors knowing that they can have a say in how their capital is utilised, essentially protecting their investment.
Below are some key clauses that can be incorporated into shareholder agreements.
1. Governance and management
A venture capital shareholders agreement could cover a whole raft of clauses that relate to the governance and management of the startup. These will be discussed and negotiated during the fundraising round and specialist advice should be sought, particularly if the founding team have little experience in this process.
The venture capitalists may want to appoint a number of members to the board of directors. This is done for good reason, the VC fund wants to protect and monitor it’s investment and the performance of the company, having a presence on the board allows them to gain information quickly and to have constant access to the management team.
In this situation it is vital that clauses are inserted that strike a balance between the founder’s vision for the company and the VC’s right to protect their investment, the board should not be able to act unilaterally in the self interest of either party. Careful consideration will need to be given to what decisions could be made as a reinforced majority, for example re-structuring decisions.
2. Equity transfers
This is a fairly standard clause to be adopted in UK shareholder agreements. In a startup, a large part of the value may lie in the founders themselves. A VC fund may essentially be investing in the team and not the business plan, this could be because of the expertise or experience held within the team. This being the case, no VC would want to find themselves in a situation where they invest in a team, only for them to transfer their equity share to a third party shortly after.
It would be normal practice for a shareholder agreement to state a minimum term that certain key people have to hold their equity in the startup before making a transfer. The average time seems to be between two and five years, but the exact term will be tailored to the circumstances of the business and investors.
As well as requiring key people to hold onto their stock, the shareholder agreement may state that they also have to engage in the business. In other words, they can’t leave to go elsewhere. Such wording will be agreed in detail but may look something like, “they engage in the business and comply with the milestones with the dedication and diligence of a reasonable and prudent businessperson”. It is likely to state that they are to devote adequate time and adopt the necessary measures to ensure the proper management and control of the company.
Drag-along rights make a provision for the VC fund to force other shareholders to sell their equity if the VC finds a buyer.
An essential part of this framework would be the strike price for any drag-along clause to become activated. To ensure the interests of all the shareholders are met, a high price should be agreed.
As a counterbalance to the drag-along clause, a tag-along clause ensures that any party cannot transfer shares to a third party without first making sure the offer has been extended to other shareholders. In practice, this means that any third party approaching a shareholder will have to also approach all other shareholders with the same offer.
4. Liquidation scenarios
A VC fund will want to ensure that during any liquidation scenario that it maintains a preferential position. Venture capital investors will want to recoup as much of their investment as possible and so they will want to be at the front of the queue when proceeds are being paid out.
A liquidation clause will usually state that during liquidation the VC fund will receive a full refund of its capital and that only after that, will other amounts be distributed amongst the other shareholders. This type of clause is designed to provide a VC fund with protection and minimise risk should the startup be liquidated or otherwise dissolved.
5. Anti-dilution measures
These clauses are important to early investors who want to know that they will be rewarded with future benefits for financially backing a company very early in its life cycle.
In future investment rounds, a VC may see their percentage stake in the company diluted, which they may want to avoid. There are several methods of preventing this, one of which is to include in the shareholder agreement a ‘preferential right of acquisition’.
Essentially this means that during any future creation of new company shares, the existing shareholders will be offered the new shares first, allowing the VC fund to have agency over their equity dilution. The shareholder agreement will specify exactly which shareholders qualify and the exact process to be followed.
It is also standard practice to include in any shareholder agreement a specific anti-dilution clause. This states that the parties will agree that future capital increases cannot occur at a value lower than the value of the fundraising round in which the VC fund made its investment. This protects the fund, since if shares are created for a value lower than that which the fund paid, the fund can request the creation of new shares to offset its loss of value.
A shareholder agreement can be complicated and may give VCs extensive rights. Ensuring that you understand the fine print and its nuances is vital to provide for the effective management of your company.
Getting professional advice and negotiating hard for clauses that are important to you can pay dividends in future, so don’t just agree to terms for the sake of getting an injection of capital.
A good shareholders agreement will be fair and ensure that new shareholders in future rounds are also treated fairly and have their rights protected. It should be a transparent and balanced safeguard for all parties involved in the ownership structure.
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